The Fed takes back half its rate cuts

The Federal Reserve left rates unchanged at its September meeting and still managed to send a hawkish message. Its updated dot plot removed 50 basis points of projected rate cuts for 2024, lifting the median projection for late 2024 to 5.1 per cent. Bond markets took it badly. The committee plans to keep policy tight for a long time.

Eighteen months of tightening

The hold came after the fastest run of increases since the early 1980s. The Fed began lifting rates from near zero in March 2022, moved in steps of 75 basis points four times that year, and delivered its eleventh increase in July, taking the cumulative rise to 5.25 percentage points. Headline inflation, which peaked above 9 per cent in June 2022, has since fallen by more than half. The committee's argument in September was that it can afford to wait and watch, but that watching does not mean easing.

What the committee changed

The decision held the federal funds rate between 5.25 and 5.50 per cent, where it has sat since July. The news was in the forecasts. Officials now expect the economy to grow 2.1 per cent this year, more than double the pace they pencilled in during June, and they see unemployment ending the year at 3.8 per cent rather than 4.1 per cent. Twelve of the nineteen participants still expect one more increase before the year is out. An economy growing that fast with a tight labour market has little need of rate cuts, and the dots now say so.

Half the cuts disappear

By taking back half its projected easing, the Fed has all but killed the pivot story that markets had grown fond of. Officials are responding to a stronger economy by raising their estimate of where rates need to stay. Bond investors who bet on a quick easing cycle are being forced out of their positions, and their selling has pushed benchmark yields to the highest in decades.

The transmission is quick. Two-year Treasury yields track the expected path of policy closely, so a higher median dot lifts them almost mechanically, and longer maturities follow as investors demand more to lock money away. The ten-year yield rose to its highest since 2007 in the day after the meeting. Mortgage rates, already above 7 per cent, price off that benchmark, and so does the cost of refinancing for companies and commercial landlords.

The dollar has moved the same way. Higher expected American rates widen the gap with Europe and Japan, where central banks are either near the end of their tightening or have barely started, and the greenback has gained against most major currencies since July. That imports a little disinflation into America and exports some pain to emerging-market borrowers with dollar debts.

Where rates settle

The deeper shift concerns the medium term. The median projection now has the funds rate at 3.9 per cent by the end of 2025, well above the 2.5 per cent officials regard as neutral in the long run. The committee is signalling doubt that the economy can return quickly to the low-rate world of the 2010s. If the neutral rate has risen, today's policy is less restrictive than it looks, which argues for holding it longer.

A real-rate lens sharpens the point. With the funds rate above 5.25 per cent and core inflation expected by officials to fall below 3 per cent next year, the inflation-adjusted policy rate would rise even if nominal rates stood still. Holding steady while inflation falls therefore tightens policy automatically, and that is the mechanism the committee is relying on rather than further increases.

Savers are the clear winners. Money-market funds and bank deposits pay the highest rates in more than fifteen years, and cash has poured into them. Borrowers on floating rates, from companies owned by private-equity firms to commercial property owners, are the losers, because the relief they were counting on next year has been pushed further away.

Lessons from 2006

The nearest precedent for a long plateau is the last one. The Fed raised rates to 5.25 per cent in June 2006 and held them there for more than a year, cutting only in September 2007 once the subprime mortgage market had cracked. The economy kept growing through most of that pause while the damage accumulated in housing credit. A plateau is comfortable for the central bank and uncomfortable for whichever borrowers took on debt on the assumption that it would end soon.

Dots are not promises

The dots have a poor forecasting record in both directions. In December 2021 the median showed rates below 1 per cent at the end of 2022, and the Fed finished that year above 4 per cent. In December 2018 officials pencilled in further increases for 2019, then paused within weeks as markets slid and went on to cut three times that year. The projections describe what officials think today, and they change when the data do.

That record is the strongest argument against taking this week's shift at face value. A sharp slowdown, a jump in unemployment or a financial accident could bring cuts forward quickly. Several shocks are already in view: the resumption of student-loan repayments in October, a strike at the three big Detroit carmakers and the threat of a federal government shutdown at the end of the month. But the Fed has been surprised by the economy's strength for a year, and core inflation remains well above target. The data to watch are the monthly inflation and payroll reports before the next meeting at the start of November, and any sign that higher long-term yields are tightening financial conditions enough to do the Fed's work for it.

The dot plot erased half the easing the market had hoped for. Yields will probably stay high until the data give the Fed a reason to change its mind, and that could take much of next year, with floating-rate borrowers and commercial landlords paying the bill in the meantime.